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U.S. Gives Banks Urgent Warning to Solve Crisis

This article was reported by Jenny Anderson, Edmund L. Andrews, Vikas Bajaj and Eric Dash and written by Mr. Dash.

As Lehman Brothers teetered Friday evening, Federal Reserve officials summoned the heads of major Wall Street firms to a meeting in Lower Manhattan and insisted they rescue the stricken investment bank and develop plans to stabilize the financial markets.

Timothy F. Geithner, the president of the New York Federal Reserve, called a 6 p.m. meeting so that bank officials could review their financial exposures to Lehman Brothers and work out contingency plans over the possibility that the government would need to orchestrate an orderly liquidation of the firm on Monday, according to people briefed on the meeting.

Flanked by Treasury Secretary Henry M. Paulson Jr. and Christopher Cox, the chairman of the Securities and Exchange Commission, he gathered the executives in person to impress on them the need to work together to resolve the current crisis.

Mr. Geithner told the participants that an industry solution was needed, no matter what, and that it was not about any individual bank, according to two people briefed on the meeting but who did not attend. They said he told them that if the industry failed to solve the problem their individual banks might be next.

A spokesman for the New York Federal Reserve Bank in New York confirmed the meeting but declined to provide details on the discussions. The Wall Street executives included the following chief executives: Lloyd Blankfein of the Goldman Sachs Group, James Dimon of JPMorgan Chase, John Mack of Morgan Stanley, Vikram Pandit of Citigroup and John Thain of Merrill Lynch. Representatives from the Royal Bank of Scotland and the Bank of New York Mellon were also present. Lehman Brothers was noticeably absent from the talks.

The meeting was reminiscent of the circumstances that preceded the near-collapse 10 years go of Long Term Capital Management. At that time, William J. McDonough, then the president of the New York Fed, summoned the heads of big Wall Street banks to the Fed to stop the failure of L.T.C.M., a hedge fund firm that had made big bets on esoteric securities using borrowed money and which had already lost $4.5 billion.

The bankers ended up committing $3.65 billion to save L.T.C.M., though Bear Stearns, the hedge fund’s clearing broker, refused to contribute to the investment. Traders from the banks wound down the fund over time, averting what might have been big losses across the financial system. But the fallout from a failure of Lehman Brothers could be even more severe, given the firm’s much larger size and its entanglements with trading partners around the globe.

Policy makers fear its losses could ripple through the financial industry at a time when banks and securities firms are trying to overcome $500 billion in write-downs.

One observer briefed on the situation described the session as a “game of chicken” between the government and the heads of the major banks.

Bank of America and two British firms, Barclays and HSBC, have expressed interest in bidding for Lehman Brothers, according to people briefed on the situation. But they have indicated that their bids are contingent upon receiving support from the government, just as it did with the rescues of Bear Stearns, and the government-sponsored agencies, Fannie Mae and Freddie Mac.

Photo

Lehmans stock price in the Nasdaq window in Times Square.Credit
Patrick Andrade for The New York Times

But Mr. Paulson and Mr. Geithner made it clear to the company, its potential suitors and to the meeting participants on Friday that the government has no plans to put taxpayer money on the line. The government is deeply worried that its actions have created a moral hazard and the Federal Reserve does not want to reach deeper into its coffers. Instead, Mr. Paulson and Mr. Geithner insist that Wall Street needs to come up with an industry solution to try to stabilize Lehman Brothers and calm the markets.

Still, some of the other Wall Street banks, facing billions of dollars in losses themselves, have resisted this approach. They argue that Lehman Brothers overreached and brought its current troubles on itself. If there are no bidders for Lehman Brothers, these banks say they can collect their collateral and liquidate the troubled firm’s assets. In this high-stake game, they may also be trying to call the government’s bluff, knowing that if push came to shove, it would provide financial support.

Mr. Geithner, who led the session, firmly stood his ground. He told the banks that this was about fixing the system and preventing the crisis from worsening.

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By the time Lehman’s shares went into a spiral this week, Fed and Treasury officials were convinced that Lehman posed far fewer real risks than Bear Stearns had back in March. The confidence by Washington officials stemmed from the fact that, after the Bear Stearns collapse, they obtained stronger regulatory powers that gave them the ability to peer into the activities and risk exposures of institutions on Wall Street.

Fed officials, for example, are now embedded at each of the big Wall Street investment banks and have at least some capacity gauge the firms’ exposure to hedge funds and other big players, as well as their positions in financial derivatives and other opaque markets. Fed and Treasury officials have also been taking the daily pulse of executives and traders on Wall Street for months, and much of that discussion has been about Lehman.

Officials detected a rising number of defections by Lehman’s institutional customers to other firms, but nothing near the panic that caused Wall Street executives to bombard Mr. Paulson with dire warnings about a Bear Stearns collapse in March.

Fed officials also saw few signs that fears about the future of the investment bank were spilling over to fears about its customers and trading partners.

And in practice, taxpayers could still end up on the hook for at least as much money as they were in the case of Bear Stearns. Lehman’s successor will still be able to borrow from the Fed’s new lending program for major investment banks, which the Fed created in response to the collapse of Bear Stearns in March. If Lehman were to borrow money and then default on its loans, the Fed’s losses would reduce the amount of money it turns over to the Treasury.

For political and economic reasons, both the Federal Reserve and the Treasury Department are loath to save financial institutions from their own folly.

But as the housing crisis has deepened, they have abandoned free-market orthodoxy, fearing that the collapse of institutions like Bear Stearns or either Fannie Mae or Freddie Mac could cripple the financial markets, and perhaps the economy itself.

One of the biggest differences between the challenge facing Lehman and the one that faced Bear Stearns is the availability of the Fed’s emergency lending program for investment banks.

When confidence evaporated in Bear, with major hedge funds pulling their prime brokerage accounts, Bear’s financing ran out almost overnight, creating a panic situation. Lehman has had the power to plug any cash shortfalls by borrowing from the Fed, though it has not actually borrowed any money from the program since March.